Early Stage Legal: Company Formation Options

company formations

Company formation options: choosing legal structure types

In this section, we will provide you with general information to help you determine the best legal structure for your company. This is not a simple decision and making a wrong choice can create ongoing and costly problems. In some cases, you may be able to correct mistakes in your company formation later. For example, adding more shares or adding new directors to a company is easy. However, in many cases it is difficult and costly to make changes--e.g., converting from one corporate type to another, raising capital into the wrong corporate type, etc.

At Early Stage Legal, we believe that the easiest way to begin the process of choosing a legal structure is to understand the company's current and future funding requirements. That is not to say that your funding requirements alone will dictate the type of company you should choose but it will help to significantly narrow the choices. Most companies cannot simply start up and grow into healthy, thriving businesses with no funding. So most entrepreneurs formulate a plan to either 1) boostrap their business (meaning self-fund their business or fund their business out of the cash flows of the business itself) or 2) raise money from third parties including debt or equity. The type of legal structure you choose will strongly influence your ability to raise outside capital.

The Company's Funding Requirements

Below we will explore three major categories of businesses based on their funding requirements and discuss typical corporate types for each category:

Equity-Funded Businesses. Businesses that will need or want equity funding generally require several additional features: the ability to incent a large group of employees, the ability to grow to a very large size, strong governance structures, the ability to grant preferred classes of stock, protection against liability and scalable tax structures.
Debt or Self-Funded Businesses. Businesses that can or want to grow with debt funding or through self-funding are generally optimized to generate cash flow for a limited set of owners and are not necessarily designed to grow very large. These businesses may not require the ability to incent a large group of employees, protect the interests of an investor class, or grant preferred stock. Also, they generally provide tax structures designed for a smaller group of owners.
Businesses where the Funding Strategy is Unclear. Many business managers are not certain whether their business will ultimately need equity funding or not, especially at the earliest start-up stage of their business.

For each of these categories there are more common legal structures than others based on what has historically worked best for the owners. Here are the corporate types that are common in each category:

Equity-Funded Businesses	Bootstrapped or Self-Funded Businesses	Funding Strategy Unclear
C-Corporations (generally Delaware)	S-Corporations LLCs Sole Proprietorships	S-Corporations Sole Proprietorships

C-Corporations

C-Corporations are the most common legal company type for companies that plan on raising outside capital like venture capital or angel financing (see Brad Feld's article). They provide investors with all of the protections that they need to feel good about investing in a highly risky company and, at the same time, they provide the company with all of the features it might need to scale to a very large size--the ability to incent employees, multiple classes of stock, limited liability, etc. The major difficulty of C-Corporations is that they are complicated to maintain (see the full comparison table below) and they have "double taxation." Double taxation means that owners of the company are taxed at the corporate level--the C-Corporation must pay taxes itself as a legal entity--and at the individual level--the individual must pay taxes on salary, payments, and distributions. Learn more>>

S-Corporations

S-Corporations are a less scalable variant of the C-Corporation without double taxation. They offer limited liability and the ability to grant stock easily. They are still fairly complicated and difficult to maintain, though easier than C-Corporations. They also enjoy pass-through taxation, or only one level of taxation, just like LLCs. Unfortunately, they are limited to having only one class of stock and no more than 100 shareholders. S-Corporations have the additional benefit that they are more easily converted into C-Corporations than LLCs. This makes S-Corporations a good choice for entrepreneurs who are unsure of their ultimate funding requirements. Learn more>>

LLCs (Limited Liability Companies)

LLCs are highly flexible entities with limited liability and no double taxation. LLCs are "pass through" entities meaning that gains and losses from the business flow through the company to the individual owners and the owners simply pay taxes as part of their individual taxes. Unlike C-Corporations, LLCs can offer multiple classes of stock, they are relatively easy to set up, and they allow for foreign investors. However, experienced or institutional equity investors generally shy away from investing in LLCs because they expose investors to a certain kind of tax risk (called Unrelated Business Tax Income, or UBTI) and they do not have the same standard, investor-friendly body of law that exists for C-Corporations. Also, structuring equity incentive programs, multiple classes of stock, etc., is more complicated and less standard than it is for a C-Corporation. At Early Stage Legal, we offer a standardized LLC package that includes simple equity incentive programs and other protections for potential investors. Learn more>>

Sole Proprietorships

Sole proprietorships are the easiest to set up and require the least up front cost because they require essentially no formal set-up and they are simply part of the individual's own tax return, so they have no separate tax status from the owner. However, sole proprietorships do not have limited legal liability. The sole proprietor is fully responsible for any corporate legal liability. Also, sole proprietorships can not generally raise growth equity from investors and cannot easily provide equity incentives for employees.

Detailed Comparison of Legal Company Types

Here is a detailed comparison of the various legal entity types currently offered by Early Stage Legal as well as the sole proprietorship which we have included for comparison purposes.

	Sole Proprietorship	C-Corporation	S-Corporation	LLCs
Formation Requirements	None	Must file with the state, state filing fees apply	Must file with the state, state filing fees apply	Must file with the state, state filing fees apply
Liability	Unlimited for owner	Shareholders are generally not liable	Shareholders are generally not liable	Members (equity holders) are generally not liable
Governance	Controlled entirely by the sole owner	Controlled by a board of directors who typically select a President and CEO to run the company	Controlled by a board of directors who typically select a CEO to run the company	Members establish governance as they see fit in the Operating Agreement
Management	The sole owner determines management structure	Required to appoint a President, board selects management	Required to appoint a President, board selects management	Members establish management as they see fit
Employee Incentives	No easy way to incent employees	Can grant ISO or Non-Qual stock options ISOs provide favorable tax treatment for employees	Can grant ISO or Non-Qual stock options ISOs provide favorable tax treatment for employees	Early Stage Legal's LLC docs provide Non-Qual-like employee incentives
Taxation	Entity is not taxed (no double taxation). Sole proprietor pays taxes on Form 1040.	Entity is taxed as its own legal entity as well as shareholders and managers (double taxation). Taxes filed on Form 1120.	Entity is not taxed (no double taxation). If there is only one owner, taxed like a sole proprietorship. For multiple owners, it is taxed like a partnership. Taxes are filed on form 1120S.	Entity is not taxed (no double taxation). If there is only one owner, taxed like a sole proprietorship. For multiple owners, it is taxed like a partnership. In this case, taxes are filed on Form 1065 and Members get K-1 forms to file as part of their 1040.
Transferability	No	Shares of stock may be transferred easily	Shares of stock may be transferred easily (with a few rare restrictions)	Transferability depends on the Operating Agreement. It can be allowed or disallowed.
Capital Raising	Individual provides capital, may be able to raise debt financing based on personal guarantees. Equity financing will be difficult or impossible.	Easily supports debt financing and can limit liability for owners Structure makes raising equity capital attractive to all kinds of equity investors.	Easily supports debt financing and can limit liability for owners Structure allows for raising equity capital but because there is only one class of stock, it will not be attractive to sophisticated or institutional equity investors.	Easily supports debt financing and can limit liabilty for owners Structure allows for raising equity capital but it depends on the Operating Agreement. Lack of standard investor protections make this a less attractive structure for most equity investors.
Ownership Restrictions	Can only be owned by one person	Can be owned by unlimited number of owners and allows for preferred owners	Can only be owned by 100 people and does not allow preferred owners	Can be owned by unlimited number of owners and allows for preferred owners, but requires additional work in Operating Agreement
Ease of Maintaining	Easy	Fairly difficult	Fairly difficult	Moderately difficult
Ability to Convert to Different Type	Can easily convert to the other types	Difficult to convert to other types	Easy to convert to C-Corp, difficult to convert to other types	Difficult to convert to other types, but easier to convert to C-Corp or S-Corp than the reverse

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